Olivia warns:Be Prepared If Interest Rates Rise in Canada!
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As an investor, you’ll want an “all-weather” strategy — one you can follow in all types of markets and every economic climate. Of course, that doesn’t mean you should never adjust your portfolio in response to changes in the investment world. And we may be close to one of those changes: Specifically, it’s quite possible the Bank of Canada (BoC) will increase its benchmark lending rate in the second half of 2010. If that happens, should you re-evaluate your bond holdings?

As you may know, interest rates help determine bond prices. If interest rates go up, the value of your existing bonds is likely to decline, because investors won’t pay you full price for your bonds when they can get newly issued ones that pay higher interest rates. And while the BoC’s actions will affect the prices of short-term bonds, your long-term bonds will likely decline even further. That’s because long-term bonds are affected primarily by expectations about inflation — and typically, when the BoC raises rates, it does so, in part, because of fears of inflation.

So what steps should you take in anticipation of a jump in short-term rates? Should you sell some of your long-term bonds now? Actually, you may not have to rush into anything. In the first place, no one can really predict exactly when rates will change. Secondly, even if short-term rates rise, there’s no guarantee that long-term rates will rise as well. But even if market rates rise, and the prices of your bonds fall, you can still anticipate two key benefits, provided the bond issuer doesn’t default. First, you’ll still collect regular interest payments, and second, you’ll be able to redeem your bond for the full face value once it matures.

If you do want to be more proactive, however, you can create and maintain a portfolio of bonds that can provide advantages in all interest rate environments. How? By owning a “ladder” of bonds of varying maturities. When market rates are low, you’ll still have your long-term bonds, which typically pay higher rates, working for you. And when market rates increase, you can use the proceeds from your maturing short-term bonds to purchase new ones issued at the higher rates.

Apart from the regular income stream and the ability to collect a lump sum, both of which you can get from holding your bonds until maturity, and beyond the interest rate protection you may be able to achieve through a bond ladder, you can gain one other important advantage from owning bonds: diversification. If a market downturn hurts stock prices, the presence of bonds may help reduce the impact on your portfolio, because bonds frequently (though not always) move in the opposite direction of stocks. (Keep in mind, though, that diversification, by itself, can’t guarantee a profit or protect against loss.)

As we’ve seen, you can “weatherize” your bond portfolio for all interest rate climates. Furthermore, bonds can offer you real benefits, no matter what’s happening with interest rates. So while it’s obviously a good idea to be aware of changes in these rates, avoid overreacting to them. By making the right long-term moves with your bond portfolio, you can make progress toward your financial goals today — and tomorrow.